There are many different types of financing options available nowadays, but small business owners are more likely to go for simple loans that require limited documentation and need for collateral, due to their limited time in business. Revenue-based financing is one option for such businesses.
Revenue-based financing is also known as royalty-based financing. It is basically a form of raising capital for a business through lenders or investors who receive a percentage of the business’ ongoing gross revenues for the money they have invested in that business. The investors are basically receiving a regular share of the income of the business till the time a predetermined amount has been paid back by the business. This predetermined amount is generally a multiple of the principal amount and may range between three to five times the original amounts that were invested. For a brick and mortar small business, this works in a similar way as merchant cash advance does.
Why should one consider Revenue-based Financing?
There are many small businesses which are looking for cash in order to grow their businesses and find it hard to borrow money from traditional lenders, such as banks or through a stock sale, etc. A small company may not be able to qualify for a bank loan because they may have a scant history, not enough tangible assets to offer as collateral or their credit scores may not be high enough. Revenue-based financing generally does not involve any personal repayment options or uses any form of personal collaterals.
Other traditional methods available to a business would be to sell a portion of the company to a couple of investors, which would be unappealing to many business owners because of the owner of the business may not want to dilute the ownership of their stock or give the control of their company to outside investors. Moreover, the company may not even be mature enough for venture capitalists or angel investors.
Revenue-based financing is becoming quite popular with the small to midsized companies which find hard to obtain funds and the traditional forms of capital needed to grow their business. Since revenue-based financing is something like becoming a business partner, the transaction costs are also lower than a conventional loan. As such, many venture capitalists are also getting involved with this form of financing especially for the businesses in the SaaS – that is the Software as a Service space.
How does Revenue-based Financing work?
Revenue-based Financing specifies the following:
- Principal Amount
This is the cash advance that is given by the provider of the loan to the borrowing company.
- Repayment Cap
This is the amount that the borrower will have to repay and it is expressed as a multiple of the principal amount that was borrowed initially. For example, a cap may be expressed as 2.0x the principal amount.
- Monthly Repayment Percentage
This is the monthly percentage of the gross revenue which the borrower has to pay the lender. This amount is a fixed percentage, which means that the amount paid out will be higher during the months when the business revenues are also high and the amount will be lower when the business revenues are also low.
This is the time period it will take for the business to repay the loan and is generally expressed in a range, for example 3 to 5 years because it varies with the revenue cash flows on a monthly basis.
- Minimum Required Monthly Revenues
The providers of revenue-based financing would want to see the revenue history or historical data which meets or exceeds a provider set minimum target for revenues over the year.
Example of a Revenue-based Financing Plan
- Principal Amount: up to 30% of the sales annually, up to $1 million
- Repayment cap: 1.5X-3.0X of the principal amount of loan
- Monthly Repayment percentage: 4-9% of the sales on a monthly basis
- Term: 2-5 years
- Minimum Required monthly revenue: $20,000 per month over the past 12 months
- Fees: Minimal, generally the legal fees reimbursement
- Tax deductible: If structured properly, Yes
- Balloon Payment: Possibility, at the end of the term
- Personal liability of the owners or partners: None
- Funding speed: Within 3-4 weeks
- Prepayment penalty: None
- Collateral: None
How to qualify for Revenue-based financing?
Just because you are a small business does not mean you automatically qualify for Revenue-based financing! There are a few requirements that a business may have in order to qualify for this form of financing.
- The FICO score should be at least 550.
- Reliable documentation is needed that is able to disclose the sales or the gross revenues
monthly, over the past year.
- The minimum gross margin should be at least 50%.
- The company will be able to borrow not more than 1/3 of their annual gross revenue.
- There is no requirement to be profitable; all you need is income of at least $20,000 per
- You have to specify how you would be using the advance as the lender would want the
money to be used for the growth of the company.
- A business bank account would be necessary so that the lender can electronically
withdraw the payments on a monthly basis automatically.
Revenue-based financing vs the Traditional Debt Financing
Traditional debt financing refers to the different types of loans which are available – most of the times this means a term loan. When traditional lenders are taking into account the revenues of a business in the application process, this means that the payments which you have to make on a monthly basis will change in line with the revenue of each month. This is different from the term loan, which has a fixed payment that the borrower has to make each month, regardless of what are their revenues. Moreover, revenue-based financing is also different from equity-based financing since there is no direct ownership of the investor in the business. This is one of the reasons why many people consider revenue-based financing as a type of hybrid between equity-based financing and debt-based financing.
Benefits of Revenue-based financing?
Most of the benefits of revenue-based financing are based on risk reduction. Most traditional bank loans require the borrower to give some form of collateral or a personal guarantee in order to give the business the required funds. This means, that the assets of the business which you were trying to protect, are at risk in case your payments to the bank go bad. When it comes to revenue-based financing, however, there is no need for a personal guarantee. If the business fails or does poorly, they will have to recourse to items that are owned by the business and the personal possessions of the business owner would not take a hit. That means the personal assets of the owner are protected.
Moreover, the business is also less likely to default in their loan payments since they do not have to pay cash from their own pocket but from the one that is coming in through the sales. Generally, the lender would be taking the cash as a percentage of the sales on a weekly or a monthly basis, depending on the cash flow of the business and since the lenders do have gross profit margin requirements in place, before giving the loan, the amount taken from them would not be unreasonably high for the business to manage.
Furthermore, a traditional bank loan does not discriminate between a good sales month and a bad sales month. With revenue-based financing, however, bad sales month would mean you would just pay less as the repayment amount is based on the inflow of cash tied to the revenues. With the traditional bank loans, the business would have had to use their cash reserves.
Finally, revenue-based financing is typically easier to qualify for as compared to the conventional loans from banks, as the lenders usually look for the small businesses whom they can lend to and look for businesses which have strong revenue streams, rather than having a history of solid cash flows.
The Drawbacks of Revenue-based financing
The biggest drawback of the Revenue-based financing is probably the price. It is the long-term cost of taking this loan. Over the course of this loan, the borrower ends up paying back the lender more than two or three times the amount that they had borrowed. For revenue-based finance providers, this is a venture capital space where the risks, as well as the payout, are higher than the banks.
If the small business loan is typically at 6-8% range, the business using revenue-based financing would be taking quite a lot of excess costs by going for this form of lending. For example, if they borrow $500,000 from a bank, the business would agree to pay them back around $600,000 over the course of around five years at interest rate of 7%. The same loan however, from revenue-based financer would be costing the business around $1 million or more! Moreover, revenue-based financing is not free from all obligations and at the end of the day, it is a loan. So if a business does not perform well and if you are unable to make you payments or the company goes under, then the lenders would come for the business assets. So for a startup, this could mean the loss of infrastructure, computers or intellectual property.
When to seek options for Revenue-based financing?
This form of raising capital is ideal for small businesses which have the following features:
- The business should be in the growth stage and are looking to hire additional sales people.
- A company in the middle of launching a new product.
- A company that wants to invest in a large-scale marketing campaign that would boost
their sales and revenues.
- A company that was an established market.
- When the owners do not want to sell their equity to outside investors or do not want to personally guarantee a loan
- When there are no options available for a bank traditional bank loan.
Is Revenue-based Financing right for your business?
A business owner must consider the following points when they decide to go for revenue-based
financing, since it may not be feasible for every type of business.
- The company should have an established revenue stream through which the owners can draw the payments for the debt servicing.
- The company should have an established market already which is also stable in nature.
- The financials of the business should be in order and the company should make sure that they have a summary of the total debt, operating expenses, revenues as well as future projections which are all accurate
It is not easy to decide which type of financing to go for when you want to grow your business. There are multiple facts which you have to consider, such as your credit, your history, your assets and as well as the time frame in which you require the funds. You must also consider how much you would be willing to pay and who you want to borrow from. Revenue-based financing can be a great idea for some businesses but not so great for others. It can be a great option for those businesses which do not have many assets to offer as collateral.
Moreover, before a business commits to any form of debt obligations, they must consider the long-term obligations they are signing up for. It is incredibly flexible, but at the end of the day, it is still a loan and as such a business should not consider it lightly. Even though the business owner’s personal assets are not at risk, the business assets certainly are and as such, they must make the monthly payments on time. It is a great tool for small businesses at the growth stage if they use it properly.